The ‘compensation’ thesis, as exemplified by the case of the Chinese central bank

Marc Lavoie and Peng Wang

International Review of Applied Economics, 2012, vol. 26, issue 3, 287-301

Abstract: This paper extends the theory of demand-led money supply endogeneity to the case of an open economy with a fixed exchange rate. This theory is contrasted to the standard Mundell-Fleming view. In the compensation approach advocated here, central banks are able to set interest rates, even in a fixed exchange rate regime, either because there are automatic market mechanisms that will induce the private sector to act in such a way that changes in foreign reserves will be compensated by opposite changes in central bank claims over the domestic economy, or because the central bank will engage in endogenous sterilization operations in its efforts to enforce its benchmark interest rate. Analyzing the balance sheet of the Chinese central bank, we find that the large rise in foreign reserves on the asset side is compensated by large positive changes in items of the liability side, mainly bonds issued by the central bank. Foreign reserves are not cointegrated with the monetary base, meaning that there is no long-run relationship between foreign exchange reserves and the supply of base money. We also find no long-run relation between foreign exchange reserves and the consumer price index.

Date: 2012
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DOI: 10.1080/02692171.2011.587108

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